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"The trend is your friend but the fade is the ultimate wealth builder." – Tom Sosnoff
One of the biggest mistakes I see new traders make is that they keep digging into the toolbox for a new widget every time they see something they like.
I can't tell you how many traders I know who want to follow bull flags, bear flags, candlestick patterns, channel retracements, Fibonacci retracements – the list goes on and on. They will try to teach you about their long list of indicators to make themselves look impressive, but in reality most are horrible traders over the long term because they overwhelm themselves with the latest and greatest indicators only to move on to another indicator that happens to fit their current market perspective.
I keep it super simple when I trade. I pick one tool and I use it for its specifically intended purpose. As an options trader, I'm looking to make steady, reliable gains without too much of a holding period.
So in order to make options trades, I use a tool that helps me do a few things:
1) It alerts me that a profitable trade may be on the horizon, which gives me time to prepare.
2) It tells me when I should think about getting out.
3) It lets me adjust my time horizon to craft a trade that fits my needs.
As I said before, I keep it very simple. I use a few basic versions of ONE simple tool to take advantage of sentiment and technical extremes on highly liquid ETFs.
So with that being said, I would like to share the most powerful technical indicator that I use in my proprietary model – the Relative Strength Index (RSI).
The RSI, developed by J. Welles Wilder, Jr. is an overbought/oversold oscillator that compares the performance of an equity – in our case a highly liquid ETF – to itself over a period of time. It should not be confused with the term "relative strength," which is the comparison of one entity's performance to another.
Basically, RSI allows me to gauge the probability of a short- to intermediate-term reversal. It does not tell me the exact entry or exit point, but it helps me to be aware that a reversal is on the horizon.
I love short to intermediate time frames for trades, because it means I don't have to lock up lots of capital for a long time in order to profit. I can put a trade on, and in many cases, close it out within a week. That goes for winners and losers. I'm in and out. If I'm wrong, I'm not wrong for long, because I cut out almost immediately if the trade doesn't pan out.
Knowing that a short-term top/bottom is near, I am able to increase the probability of a potential trade. Conversely, knowing that a reversal is on the horizon I am able to lock in profits on a trade.
I am a contrarian at heart. I prefer to fade an index – whether overbought or oversold – when the underlying index reaches a "very overbought/very oversold" state. Fading just means to place a short-term trade in the opposite direction of the current short-term trend.
Of course, other factors must come into play before I decide to place a trade. But I know that in most cases, when an index reaches an extreme state a short-term reversal is imminent.
The following is the guideline for my "High-Probability Trades:"
Very overbought – an RSI reading of greater than or equal to 85.0
Overbought – greater than or equal to 75.0
Neutral – between 30.0 and 75.0
Oversold – less than or equal to 30.0
Very oversold – less than or equal to 20.0
Since I'm looking for extreme conditions, I almost always focus only on very overbought and very oversold conditions. When an asset hits more neutral levels, that's an indication to close the trade out.
I use three different RSI time frames – the shorter the duration of the RSI, the more I want to see an extreme reading. The time frames are RSI (2), (3) and (5) days.
So now that you have the basics of the strategy, let me go over a few examples.
The following examples are trades that I recently closed in my Options Advantage portfolio.
Background: The iShares FTSE China 25 Index (FXI) surged roughly 18.7% over the course of six trading days starting October 20th. The surge lasted until October 27th, at which time FXI pushed into a short-term "very overbought" extreme.
You can see the "very overbought" state across every RSI timeframe in the chart below. While this does not occur often, when it does it is a high-probability trade and one that should be taken advantage of.
Again, the RSI (2), (3) and (5) readings below the chart clearly show that a short-term overbought extreme had been hit. At that time, I want to make sure my other proprietary indicators line up. If so, I will fade the move.
Remember that fading means placing a trade that opposes the current trend. In this case the move was higher; therefore I bought puts. (Remember, you make money buying puts if the underlying asset goes down.) Had FXI been at a short-term oversold extreme, I would have bought calls.
The trade:
When entering the trade using options, I always look for a delta between 0.50 and 0.70. This means that for every $1 move in the underlying ETF, I will make $50 to $70 per option contract (assuming, of course, that I'm right on the direction of the move). Moreover, I look for an option price in the $2.50-$3.00 area ($250-$300 per contract). (If you have any questions about delta – one of the "Greeks" – drop me a line at [email protected]).
I choose a delta in the 0.50 – 0.70 range for risk-management reasons. Choosing an option with a delta of 1.0 would be way too risky and potentially fatal if the underlying ETF moves in the opposite direction of your position. On the other hand, a delta below 0.50 would require a large move in the underlying ETF and I do not want to wait for an extended move.
Remember, RSI over the timeframes of (2), (3) and (5) takes advantage of short-term extremes. I do not want to be in a trade for longer than a week, if possible. When using the RSI indicator, my average trade lasts roughly one to five days, so choosing an option that would require a large move over five days is unrealistic.
So, back to the trade.
With FXI moving into a short-term extreme on 10/27, I bought the FXI Dec 39 put for $2.28. Two trading days later, I sold these puts for $3.35 for a gain of 46.9%.
Again, I keep it simple, very simple. Why would I attempt to create a complex options strategy when my strategy has a win ratio of more than 88% with an average return of more than 8% per month?
Why would I want to use an arsenal of gizmos and widgets, when I can use a simple tool like a hammer to get the job done?
Simple equals boring, and often that does not entice traders. But I am not here for excitement. I'm here to provide a sound options strategy that makes people money over the long haul. And that's exactly what the RSI strategy succeeds in doing.
As always, please do not hesitate to email at [email protected] with any questions that you might have.
Andy Crowder
Editor and Chief Options Strategist
Options Advantage and The Strike Price